China’s economic outlook remains favorable

The World Bank released its latest Quarterly Update on China’s economy on Friday (for disclosure's sake: I’m the lead author). At the press launch, there were a lot of questions about the recent wage hikes in several foreign-owned manufacturing companies and the possible concerns these have triggered among many about possible loss of competitiveness and/or a wage-inflation spiral. There were also, as usual, quite a few questions about the exchange rate.

Meanwhile, the People’s Bank of China over the weekend announced the plan to re-introduce more flexibility in the exchange rate regime, after almost 2 years of a de facto peg to the US dollar. This is likely to set the stage for a stronger exchange rate over time.

In this blog post I summarize our main conclusions and views, including our fairly sanguine views on the implications of the wage increases and our quite positive assessment of developments and prospects generally. I would argue that the timing of the move on the exchange rate suggests that China’s authorities broadly agree that, overall, the outlook on exports, growth, and competitiveness in China is fairly good.

In a later post, coming out in a few days, I will focus on the medium term scenario that we did as background work for this quarterly.

In our view, economic developments have largely been favorable. Growth has been strong, with some softening recently. Real estate construction has been an important driver of growth while consumption has held up well, reflecting a healthy labor market. Export volumes have recovered rapidly since the trough in early 2009. Indeed, they have grown faster than world imports, resulting in further market gains, reflecting the strong fundamental competitiveness of China’s manufacturing industry.

In all, growth has become less reliant on stimulus. Government-led investment has slowed substantially and overall investment has also slowed. More recently, leading indicators and industrial production data suggest that activity is decelerating somewhat. Inflation has picked up because of food prices and housing related costs, but core inflation remains low.

One area where the situation is complicated is real estate. Property prices rose very rapidly in much of 2009 and the first part of 2010. That was unsustainable. The government took measures to contain these price rises, emphasizing tightening the access to mortgage financing. The government did not really want to see real estate activity slow dramatically. But that is what some are now afraid of, and that underlines the challenges in this part of the economy.

Looking ahead, China’s outlook remains broadly favorable. Internationally, growth in many high income countries is likely to be subdued in the coming years, as they face fiscal consolidation and skeptical financial markets. However, overall, global growth prospects remain quite good. Projections for global growth done recently are stronger than those done at the start of the year. This is largely because of good prospects for emerging markets, which generally have come out of the global crisis in good shape. And, growth in the core euro zone was never expected to be very rapid in the first place this year, and the downgrades to growth there have been mild.

In China itself, we expect growth to ease somewhat throughout 2010 after the strong first quarter. This is largely because of a further normalization of the macro policy stance and the lagged impact of the measures introduced in mid-April to contain property price rises. Global growth and import demand may also ease, sequentially, after the strong start to 2010. In all, we project 9.5 % GDP growth for 2010 and 8.5 % for 2011. In terms of the composition, we think growth is going to be less driven by investment this year and benefit from more favorable external trade. Consumption is likely to remain supported by a strong labor market, which boosts household incomes and confidence.

We think inflation will remain contained and do not expect an unwarranted wage-price spiral. This is in part because globally there are no inflation pressures. There is still a lot of spare capacity around the world, both in manufacturing sectors and in raw commodity markets. This will continue to dampen price pressures globally for a while. Domestically, the China-specific factors behind the food price increases are not likely to persist. Moreover, core inflation remains very low. Under China’s pattern of growth, increases in supply are large compared to increases in demand. And, as shown in the figure below, despite substantial wage growth in the recent decade, unit labor cost (ULC) increases in manufacturing have remained low, because of rapid productivity growth and upgrading. It is not obvious that this is going to change rapidly.

What about the large wage increases recently? This is in large part a cyclical issue, reflecting the strong rebound in the labor market after an earlier downturn last year when wage growth slowed. When you look at the recent increases in factory wages or the minimum wages over a 2 year horizon, they are not far of historical norms. It is likely that the recent wage hikes encourage higher wages elsewhere. How individual companies will respond will vary. However, given the track record of manufacturing to keep ULC growth under control and the flexibility of the labor market, it still seems unlikely to me that a worrisome wage-inflation spiral will result from this.

What about structural trends? The recent wage increases take place against a backdrop of discussions about the possible exhaustion of China’s surplus labor. When a large part of the labor force is working in agriculture, at low incomes, rising demand for labor from industry can be met without high wage increases. Once all the surplus labor is absorbed, rising demand will lead to larger wage increases. This is the time in a country’s stage of development that we start to see significant sustained real exchange rate (RER) appreciation.

As argued in the companion paper to this Quarterly on medium term issues (527k pdf) looking at the historical patterns in other countries, China does not yet seem to be at the stage where surplus labor is exhausted and this leads to a structural tightening of the labor market and RER appreciation. In principle it is possible that things are different in China, maybe because demographic changes associated with ageing will affect the country at a relatively early stage of development, compared to other countries.

However, looking at the timing and pace of these upcoming demographic trends and observing that there are still large numbers of people working in low productivity activities and receiving low incomes, both in the country side and in cities, this type of sustained tightening of the labor is yet not likely to take place in the coming years.

All in all, in my view, the outlook for China remains largely favorable.

The Quarterly also discusses the implications of this outlook for macroeconomic policy as well as structural reforms, with an emphasis on public finance, social protection, and labor market reforms. It also looks at the role of state-owned enterprises (SOEs) and at a medium term scenario. I will get back to the medium term outlook and some implications in another post.

Comments

On page 11 of the Quarterly Update, you write: "However, inflation is basically determined by supply and demand for goods and services and China's prices are strongly influenced by global prices." No. PRICE is determined by supply and demand. Ceteris paribus, double the money supply and prices will rise with no change in supply, no change in demand. My textbook reads: "The existence of a close link between the price level and the money supply in an economy is one of the oldest and most reliable conclusions about macroeconomic behavior, having been recognized in some form for hundreds if not thousands of years. (Able, Bernanke and Croushore; p. 251)
The next sentence reads: "Higher food prices and imputed rent are exerting some upward price pressure." So "imputed rent" is "strongly influenced by global prices?"

Dan,
It is good that you bring this up. The view that prices are determined by money supply is one of the most widely held in economics. In my view, it is also one of the most misleading ones. Bernanke et al wrote in their textbook about a link [read link in italics] between money and prices. However, in economics many things are linked. They did not write that prices are determined by money. Moreover, the institution headed by Bernanke--the US FED--,as well as most other major central banks have in recent decades stopped looking much at money as a determinant of inflation. That is because empirical research in recent decades has shown that the causal link from money to prices is very complex and indirect at best, especially in anything but the very long term. Thus, if you look at FED reports of the last 10 years, there are virtually no references of the words M1 or M2 close to inflation. Instead, output gaps and capacity utilization feature as the dominant drivers.
I agree with most major central banks who have concluded that prices are basically determined by supply and demand on the markets for goods and services. In the case of China, M2 and credit grew by 30 % last year and are set to grow by another 18 % or so this year. However, as long as demand in China's real economy will not exceed supply by a large margin this year, inflation is unlikely to exceed 4 %.
China's real economy is fairly well integrated in the world economy via trade channels. That is why we see global price developments reflected in China. That is true for raw commodity price movements and prices of manufactured products. China is lucky at the moment. There is not a lot of spare capacity in its own economy, but there is a lot of spare capacity in the world economy. That global spare capacity is containing price pressures at the moment, globally and in China.
But, you are right, in any economy there are non-tradables, whose prices are little if at all affected by global prices. Houses and housing costs are a prime examply. These prices can rise in China even in a context of downward price pressures globally.
Indeed, this is why, while I have remained quite sanguine about goods inflation in China amidst the dramatic increase in M2, I have been concerned about the impact of all that liquidity on asset prices, notably house prices.

Dan, thank you too. I agree that it would be good to have an explicit discussion about it. Many economists working on China have traditionally been squarely monetarist in their discussions about inflation. I have over the years read many reports on China asserting a close causal link from M2 to CPI inflation with a certain number of months lag (or a close link from the difference between M2 growth and M1 growth to CPI inflation). I thought last year's monetary explosion was going to be interesting in this regard. I thought monetarists would have to start projecting very high inflation for this year. But they have not done that. Why does this not happen? Are people adjusting their framework or are there special circumstances?
By the way, these are genuine questions, not rethorical ones.
Do you expect substantially higher inflation than the consensus of 3-4 % this year or next?

"Moreover, the institution headed by Bernanke--the US FED--,as well as most other major central banks have in recent decades stopped looking much at money as a determinant of inflation"
and
"China's real economy is fairly well integrated in the world economy via trade channels"
Could the reason that the FED and other central banks have a relaxed view on the M2 be that they are interconnected with other countries through both trade and financial channels?
The RMB still has some way to go before it becomes a mayor part of the world financial channels. It means that the excess liquidity in the Chinese M2 has to be allocated outside of China via trade channels by buying commodities or goods. My fear is that the excess money simply does not leave China fast enough. I am pretty sure exchange through trade channels will be slowed down because trade is becoming more political sensitive as unemployment rates rise.

Anders, thanks for your comment and question.
I think the key reason that the FED and other central banks nowadays don't look a lot at M2 as a determinant for inflation is that they consider capacity utilization (the demand and supply balance on the markets for goods and services) as the key driver of inflation. Thus, they would not care too much about M2 even in a closed economy. But it is true that openness via trade has in recent decades allowed for a lot of negative pressure on prices to spread around the world.
I would be worried, though, about the impact of soaring M2 on asset prices. In this sense I would agree with you that there is a risk that the "excess money simply does not leave fast enough." Opening up the capital account to outflows may release some of this pressure. However, this could run into other complications, and, at the end of the day, the only way to contain the risks associated with rapidly rising M2 is to reduce the pace of expansion.

First of all. Thank you for taking the time to answering our questions. So few scholars take their public servant responsibilities serious.
The rise in the M2 and the focus on fixed assets within the investment scope of the fiscal expansion in 08/09/10 does, as you and I agree on, leaves the Chinese with "over" capacity issues in certain sectors. If the growth rate within the GDP has to be sustained, then consumption (C) has to grow and all things being equal the other components of the economy (I,G,X-M) have to stay at their current level or rise. Correct me if I am wrong.
What is your evaluation (roughly) of the scope for the Chinese government to stimulate C ? I agree with you that stimulating G and I through fiscal expansion has worked, but it seems to me that stimulating C in China is a different thing altogether. By my account there, for China especially, are serious side effects connected with such stimulation: unemployment, social imbalance, less state control and negative effects on the export sector.
I was hoping for your opinion on what macro tools there would be relevant for the Chinese in stimulating consumption
I have read your post from June last year, but still could you elaborate over this subject at a given time.
Best Regards

Anders,
I agree that rebalancing the pattern of growth is important, and one of the reasons is to ensure that growth can be maintained even if exports will eventually start slowing down. The rebalancing will need to be towards more emphasis on services and consumption, away from industry and investment. There has been some progress, notably in the beefing up the role of the government in health, education, and social security. However, compared to the momentum of the existing pattern, progress in terms of policy measures has been modest. Thus, more is needed. In my view, two types of structural reforms are needed.
First, reforms are needed to ensure that new resources are channeled to sectors that should grow in the new setting, instead of to sectors that have traditionally been favored and done well. These means (i) financial sector reform, to improve access to finance for private sector, service oriented, and smaller firms; (ii) adjustment in prices and taxation, to remove subsidization of industrial inputs; and (iii) revision of the dividend policy for SOEs, to improve the allocation of capital. In addition, opening up several service sectors to the private sector and removing unnecessary regulation and restrictions could boost growth and employment.
Second, policy reforms are needed to support high quality, permanent urbanization. To get a more thriving, service sector-oriented domestic economy, China needs more migrants to settle themselves permanently in the cities. Urban people consume more than rural people, in particular spend more on services. More permanent migration is key in fostering the more labor intensive urban growth and higher shares of wage income and consumption that the government is looking for. Obvious reforms to promote successful, permanent migration and urbanization are: further liberalization of the Hukou system; land reform; and reform of the inter-governmental fiscal system to give municipalities the resources and incentives to provide basic public services (notably education and health) to migrants.

Hello Louis:
Thank you very much to let me one good opportunity to read your paper, it is very specific and exact. It also let me enjoy the happiness of study and analysis.
I have 2 questions as below:
1) Could you explain the full name of these 2 abbrevation words of CHIBOR and LIBOR? I can see them often in financial field.
2) In your opinions, China's bank system will increase the interest rate this year or not do? If yes, When would happen? and what effect or affect will be brought in?
Appreciation to your answers and your research!
Jun

Jun,
2) Not being a private sector economist I am in the comfortable position that I don't really forecast policy moves. At the World Bank we express our views on policy issues, disclosing what we would do if we were policymakers. If I were in charge of China's macroeconomic policy, I would tend to use the interest rate instrument more. In particular, whenever there is a need to tighten policy, I would rely more on a higher interest rate and less on administrative measures, changes in prudential regulation and credit controls.
1) For next time, if you want to know things such as the meaning of Chibor and Libor, I recommend such googling the terms. But, anyway, these are basically market interest rates on the interbank market. Libor stands for the London Interbank Offered Rate, and the Chibor is the Chinese equivalent.